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Take it or leave it: new rules offer harmony for Europes accounting standards, but who will play by them? The European Union wants consistent guidelines for financial reporting to be adopted from next year but many banks and insurers say the measures could adversely affect their balance sheets, write Andrew Parker and Charles Pretzlik
ANDREW PARKER and CHARLES PRETZLIK. Financial Times [London (UK)] 31 Mar 2004: 17.

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Abstract
Retail banks complain that IAS 39 would wreck risk management strategies because it pays no attention to how they deal with deposits and loans. Banks use derivatives to cover net risk exposures on their deposits and loans and many EU financial institutions want the IASB to make further changes to IAS 39 that would prevent volatility in shareholders' equity. On March 12 the European Banking Federation, which represents 4,000 banks in 19 countries, made a new proposal for changing IAS 39, which it said provided "a possible means of overcoming the critical difficulties". The volatility in accounts provoked by IAS 39, the IASB's set of derivatives rules, stems from its requirements that derivatives be measured at fair or market value in balance sheets, and that annual gains or losses on the financial instruments be shown on profit and loss accounts. Currently derivatives often do not appear on European balance sheets because, as contracts to pay or receive cash in the future, they have little or no initial cost. It would be a seismic shift for companies to make disclosures about derivatives that are based on fair value accounting rather than historic cost. It also explains why European Union companies think that, of all the IASB's standards, IAS 39 will have the biggest impact on them (see chart, left). IAS 39 is based on US financial reporting rules that require fair value measurement of derivatives. Some banks have given clues about the likely impact of IAS 39 because they show the impact that the equivalent US rules have on their income statements. For example, Barclays recorded a loss on derivatives of Pounds 1.1bn in its 2003 income statement under US rules, compared with a gain of Pounds 553m in 2002. HSBC recorded a loss of Dollars 613m on derivatives in 2003 under US rules, compared with a Dollars 221m gain in 2002. However, IAS 39 offers the opportunity to minimise volatility in profit and loss accounts if companies can show that derivatives are used in risk management activity known as hedging. For example, derivatives are bought to guard against adverse changes in foreign exchange or interest rates. Derivatives may hedge the risk that a rise in interest rates could affect bank customers' ability to pay interest on their loans. But the hedge accounting regime in IAS 39, which reduces

volatility in income statements, does not satisfy many banks because it often requires them initially to record annual gains or losses on derivatives in shareholders' equity (see chart, left). IAS 39 threatened to impose huge implementation costs on banks. This was because they would have had to document how one derivative hedged a single asset or liability. The cost of computer systems to provide the relevant documentation would be enormous. The IASB today publishes changes to IAS 39 that will allow companies to demonstrate that a derivative hedges a portfolio of assets or liabilities, rather than single items. As a result, the compliance costs are reduced. Insurers are affected both by IAS 39 and IFRS 4, the IASB's standard on insurance contracts. Last year insurers such as Allianz, Aviva and Axa expressed strong concerns about the volatility in accounts that stems from how they must measure insurance assets at fair value but record liabilities on an "amortised cost" basis. But the IASB has rejected calls by insurers for changes that would allow them to measure assets that finance their liabilities at amortised cost.

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When Frits Bolkestein andSir David Tweedie met for dinner in Brussels in Januaryit was never going to be convivial. The surprise was the speed at which the conversation turned sour. It was over their starter of crab and avocado that Mr Bolkestein, the Europeancommissioner responsible for the European Union's single market, told Sir David, chairman of the International Accounting StandardsBoard, to end his bitter dispute with some of the EU's biggest financialinstitutions. At issue was the IASB's plans for new accounting standardsthat would govern Europe's leading companies - proposals that have sparked outcry from many banks and insurers and that must be approved by the Commission. Mr Bolkestein, who does not pull his punches, warned that the Commission was likely to reject the IASB's flagship accounting standardon financialinstruments including derivatives the most controversial part of the board's project - unless the dispute was settled amicably. Sir David, who also relishes a verbal scrap, had no chance to respond: Paul Volcker, chairman of the trustees who supervise the IASB, was present and had already taken exception to Mr Bolkestein's demands. "We probably won't agree," Mr Volcker, a former chairman of the US Federal Reserve, told Mr Bolkestein. "The IASB produces a standardyou take it or leave it." Those bad-tempered exchanges were one of the lowest points since the Commission proposed in 2001 that the EU's 7,000 listed companies should produce results under international accounting standardsfrom 2005. Today the IASB publishes what is supposed to be its final word on the standardsthose companies should use from January. For most companies and investors, attention will focus on the IASB's changes to its derivatives rules, known as IAS 39, and a new standardon insurance contracts, IFRS 4.

But today's announcement will not satisfy the many banks and insurers that have been at loggerheads with the board for the past year over accounting for derivatives and insurance. Sir David will be under intense pressure to make concessions over the next nine months with the result that companies supposed to be abiding by the board's standardswill not know their final form for some time. And the Commission is warning that it could reject the questioned measures unless a compromise is reached with concerned banks and insurers. How did an apparently sensible initiative to harmonise accounting across Europe come to cause such conflict? After all, the reform is deemed essential if the EU is to complete its single market. A common set of accounting rules across EU member states would eliminate a barrier to cross-border share trading by making accounts more transparent. Increasing the ability of investors to compare companies should attract more investment and reduce companies' cost of capital. Corporate scandals at companies such as Enron, Ahold and Parmalat exposed big shortcomings in national accounting rules in the US and Europe and supposedly enhanced the case for a switch to the IASB's standards. While the US continues to use its own accounting rules, Sir David is working with the FinancialAccounting StandardsBoard, the IASB's US counterpart, to create a single financial reporting"language" for multinational companies. But powerful voices have expressed strong doubts about fundamental parts of the IASB's accounting methods. The EuropeanCentral Bank last month warned the standard-setter's approach could exacerbate boom and bust economic cycles. Jacques Chirac, the French president, made an unusual foray into accounting last year to say the IASB's rules could have "nefarious consequences" for Europe's economies. The roots of the dispute between the IASB and Europeanbanks and insurers over IAS 39 lie in companies' expectations that the derivatives rules will generate huge volatility in their accounts. The need to measure derivatives at fair or market value could slash their profits and shareholders' equity (see right, and charts below). French banks have led opposition to IAS 39, although their concerns about how it could undermine legitimate risk management practices are found across the industry in Europe. Jean Laurent, chief executive of Credit Agricole, France's second largest listed bank, says it will not implement IAS 39 without changes. "You are going to have banks where no one will understand the accounts," he says. "The managements are not going to be able to manage the business." Daniel Bouton, chairman of Societe Generale, France's third largest listed bank, says: "The IASB adopted rules that are not only inappropriate and misleading for users of financial statements but also will have a very significant negative impact on the financialstatements and possibly on the economy as a whole." Some banks fear that IAS 39, if coupled to a steep rise in interest rates, could dramatically cut shareholders' equity and put them in breach of minimum capital rules set by regulators such as the Basel Committee on Banking Supervision.

Many EU insurers are just as angry as the banks. Under IAS 39 and IFRS4, insurers must measure many of their assets at fair value but will record liabilities on an amortised cost basis. Such divergent accounting treatments will lead to marked volatility in accounts. The ECB, meanwhile, last month warned that "fair value" accounting could prompt banks to lend too much in upturns and too little in downturns. "Systemic risk could increase, an illustration being the fuelling of an asset bubble during economic upturns through generous credit conditions and higher collateral values," said the ECB. "The subsequent bursting of the bubble may result in a banking crisis and a credit crunch." uch a torrent of criticism forced the IASB to review the derivatives rules, which the board deems necessary to increase transparency (see right). But a concession in November to cut the compliance costs associated with IAS 39 does not go far enough for many banks. Retail banks complain that IAS 39 would wreck risk management strategies because it pays no attention to how they deal with deposits and loans. Banks use derivatives to cover net risk exposures on their deposits and loans and many EU financialinstitutions want the IASB to make further changes to IAS 39 that would prevent volatility in shareholders' equity. On March 12 the EuropeanBanking Federation, which represents 4,000 banks in 19 countries, made a new proposal for changing IAS 39, which it said provided "a possible means of overcoming the critical difficulties". While the IASB has not commented publicly on the merits of the EBF's proposal, the FinancialTimes has established that the IASB has strong doubts about it. Separately, the IASB has rejected a proposal by insurers on how to avoid volatility in their accounts. Furious with the lack of progress, senior figures at some leading banks and insurers last month denounced the IASB and urged the EuropeanCommission to develop an EU standard on financialinstruments. They included Rolf Breuer, chairman of Deutsche bank, Henri de Castries, chairman of Axa, and Sir George Mathewson, chairman of Royal Bank of Scotland. The chances of the IASB's reaching common ground with the banks and insurers have been complicated by Sir David's ferocious defence of the board's independence. The IASB has taken a dim view of the Commission's efforts to secure a compromise on IAS 39. To several board members the Commission appears to be a political lobbyist for the banks and insurers. Mr Bolkestein's spokesman denies charges of political interference and warns that the IASB could lose the EU, its biggest sponsor, if the Commission cannot endorse IAS 39. "Who is the IASB going to be making standardsfor?" he asks. "The Solomon Islands?" Friends of Sir David say he could lose his job over the affair. His five-year term as chairman ends in 2006 and he may find it hard to secure another mandate if the Commission is hostile. Meanwhile the deadlock over IAS 39, and uncertainty over whether the Commission will endorse it, is dividing Europeancompanies. HSBC, the UK's biggest bank, is signalling that it will apply IAS 39 whether or not the Commission approves it. "There would be strong peer pressure for the largest banks to adopt it," says Douglas Flint, finance director of HSBC. The bank has a US share listing and must show how its financialstatements differ under US accounting rules compared with UK equivalents - an expensive exercise. Mr Flint supports convergence between US and

international accounting standards, which could end the need for companies such as HSBC to produce two sets of results. If EU companies are not using IAS 39 from 2005, the Securities and Exchange Commission, the chief US financialregulator, is unlikely to drop its requirement for a set of results presented under US accounting rules. Many Europeancompanies outside the banking and insurance sectors are losing patience with the stand-off. Calling for a compromise on IAS 39 that would enable the Commission to endorse it, the chief financialofficers of AstraZeneca, Nestle, Philips, Siemens and Unilever say one of their overriding concerns is to get some certainty about the IASB's rules for 2005. "Such an endorsement would bring back certainty and transparency to financialmarkets and would enhance the reputation of Europeancapital markets," they say. But unless peace breaks out between Sir David and the IASB's opponents, the companies are unlikely to get the certainty they crave. Critics of the International Accounting StandardsBoard wonder at its own accountability and standards. They say it has poor governance, weak consultative arrangements and an "ivory tower" mentality that detaches it from business and economic realities. The EuropeanCommission is pressing for significant changes to the IASB's governance that would increase the European Union's influence over the board."The model they have is a little bit isolationist, a little theological," says a spokesman for Frits Bolkestein, the European commissioner responsible for accounting matters. "There is a lack of confidence. People do not trust them. If you lose trust it is very difficult to get that trust back." Daniel Bouton, chairman of Societe Generale, the French bank, says: "There seem to be great difficulties in the quality of the dialogue between Europe and the IASB. This is bizarre." Asked if he likes Sir David Tweedie, the board's chairman, he replies: "I much appreciate and I much respect people who are devoted fully to their task, even if the basic assumptions are flawed." The IASB's 14 members are mainly accountants who went into academia, national standardsetting or industry, and they come from the US, Europe, Asia and Africa. However the most influential members are Sir David; Tom Jones, vice chairman; Jim Leisenring, a former official at the US accounting standards-setter; and John Smith, a partner at Deloitte's US business. That these four members come from the UK and the US has given rise to claims of Anglo-Saxon bias that critics say is reflected in the IASB's appetite for fair value accounting. This is more widely used in the UK and the US than in continental Europe and causes greater volatility in companies' financialstatements compared with the alternative of historic cost accounting. The IASB's members are appointed by a group of trustees led by Paul Volcker, former chairman of the US Federal Reserve. The EuropeanCommission wants greater representation on the IASB for countries using international accounting standards, which do not include the US. It also wants more of the IASB's members to come from corporate or investor backgrounds, and for its standardsto go through intensive public consultation.

In December the IASB published the bulk of its derivatives standardsand related guidance, which ran to more than 450 pages. The standardswere first released, in draft form, in June 2002, and Mr Bolkestein's spokesman criticises the way the IASB did not give companies or investors any revised versions of the standardsbetween then and last December. Sir David admits the IASB has made mistakes in its consultation procedures, and plans remedies. But he also highlights the IASB's heavy workload, given the 2005 deadline and the need to overhaul accounting standardsand devise new ones. "We have changed half our standards," he says. "As I said to the Commission, 'You try and change half your directives in two years. See how you get on.'" REVISED TREATMENT OF DERIVATIVES WOULD BE A SEISMIC SHIFT The International Accounting StandardsBoard is determined to shine a light on the widespread use of derivatives by companies because it believes some have been hiding big losses on the financialinstruments. The volatility in accounts provoked by IAS 39, the IASB's set of derivatives rules, stems from its requirements that derivatives be measured at fair or market value in balance sheets, and that annual gains or losses on the financialinstruments be shown on profit and loss accounts. Currently derivatives often do not appear on Europeanbalance sheets because, as contracts to pay or receive cash in the future, they have little or no initial cost. It would be a seismic shift for companies to make disclosures about derivatives that are based on fair value accounting rather than historic cost. It also explains why European Unioncompanies think that, of all the IASB's standards, IAS 39 will have the biggest impact on them (see chart, left). IAS 39 is based on US financial reportingrules that require fair value measurement of derivatives. Some banks have given clues about the likely impact of IAS 39 because they show the impact that the equivalent US rules have on their income statements. For example, Barclays recorded a loss on derivatives of Pounds 1.1bn in its 2003 income statement under US rules, compared with a gain of Pounds 553m in 2002. HSBC recorded a loss of Dollars 613m on derivatives in 2003 under US rules, compared with a Dollars 221m gain in 2002. However, IAS 39 offers the opportunity to minimise volatility in profit and loss accounts if companies can show that derivatives are used in risk management activity known as hedging. For example, derivatives are bought to guard against adverse changes in foreign exchange or interest rates. Derivatives may hedge the risk that a rise in interest rates could affect bank customers' ability to pay interest on their loans. But the hedge accounting regime in IAS 39, which reduces volatility in income statements, does not satisfy many banks because it often requires them initially to record annual gains or losses on derivatives in shareholders' equity (see chart, left). IAS 39 threatened to impose huge implementation costs on banks. This was because they would have had to document how one derivative hedged a single asset or liability. The cost of computer systems to provide the relevant documentation would be enormous. The IASB today publishes changes to IAS 39 that will allow companies to demonstrate that a derivative hedges a portfolio of assets or liabilities, rather than single items. As a result, the compliance costs are reduced. Insurers are affected both by IAS 39 and IFRS 4, the IASB's

standardon insurance contracts. Last year insurers such as Allianz, Aviva and Axa expressed strong concerns about the volatility in accounts that stems from how they must measure insurance assets at fair value but record liabilities on an "amortised cost" basis. But the IASB has rejected calls by insurers for changes that would allow them to measure assets that finance their liabilities at amortised cost.

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Company/organization European Union (NAICS: 926110) European Commission (NAICS: 928120; SIC: 9621) HSBC USA Inc (NAICS: 551112, 523930) Take it or leave it: new rules offer harmony for Europes accounting standards, but who will play by them? The European Union wants consistent guidelines for financial reporting to be adopted from next year but many banks and insurers say the measures could adversely affect their balance sheets, write Andrew Parker and Charles Pretzlik:[LONDON 1ST EDITION] Financial Times 17 0 2004 Mar 31, 2004 2004 COMMENT&ANALYSIS London (UK) The Financial Times Limited London (UK) United Kingdom Business And Economics--Banking And Finance, Political Science 03071766 Newspapers English NEWSPAPER 249502752 http://ezproxy.rowan.edu/login?url=http://search.proquest.com/docview /249502752?accountid=13605 (Copyright Financial Times Ltd. 2004. All rights reserved.) 2010-06-12 ABI/INFORM Global << Link to document in ProQuest

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